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M&A outlook: Sellers' market continues

INSIGHT ARTICLE
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August 10, 2017

Michael Grossman

How has the first half of 2017 shaped up in terms of dealmaking and mergers and acquisitions (M&A), and what will the second half bring? Michael J. Grossman, principal and national transaction advisory services leader for RSM US LLP, shares his thoughts.

What has the M&A climate been like in 2017 and what’s expected during the remainder of the year?

It’s been the same tune for the past several months; capital deployment remains a challenge. Despite record amounts of capital raising and overhang, valuations and heightened competition continue to constrain deal flow. It’s a sellers’ market now, and I think that will remain for the second half of 2017. Increased pricing and intensified competition among private equity firms chasing the best deals will likely continue into early 2018.

What factors have affected deal flow this year?

The domestic and global economies are relatively steady and this has likely given some sellers the confidence to value their businesses at a higher level. There’s plenty of capital out there to buy these businesses, and there’s fierce competition to go after those prime deals, private equity firms are getting out priced, unable to spend their growing capital. It’s a problem for some as they have to answer to their funding partners and have a limited time to deploy that cash. Some are getting outbid by strategic buyers, too, who are willing to pay even higher prices, and a long-term infrastructure build strategy. For instance, a middle market private equity often looks for a business to invest in over a period of time, buying the business at a lower cost, developing the structure, operations and services over months and sometimes years, and then exiting at a later date when the business has matured and increased its value. It’s a more prolonged process. With these high valuations, discounted immature businesses with long-range promise aren’t there. Middle market private equity firms aren’t getting the deal choices they once had, and some are feeling that pinch.

In terms of deal flow, what industries have been hot this year and what’s cooled off?

The technology industry has continued to be hot and, likewise, technology within other industries has been upwardly trending, from fintech (technology in financial services) to technology in the automotive sector. It’s tech, tech, tech across the board. In addition, the consumer products industry has continued to see active deal flow, as well as the health care sector; however, there are some unknowns about how pending legislation may affect deals in the health care industry. Meanwhile, business and professional services has been an active deal flow area in 2017 but we are not seeing the same level of growth lately.

What are sellers doing to appeal to buyers?

Some aren’t doing anything. They’re taking advantage of the high projected valuations and intense competition out there, hoping they’ll get the sale price they want without making business improvements. Unfortunately, this is affecting the overall quality of deals in some cases. Our guidance to them is make yourself more appealing to buyers. It’s to your advantage. Improve your systems and technologies, complete sell-side due diligence so you’re positioned optimally for the sale, demonstrate your growth to potential buyers and invest in getting the right infrastructure in place. In the long run, all of this will provide more value to you when you get ready to sell. Just like a freshly remodeled home with an open floor plan, economy-saving heating and cooling and new roof would sell for more than a home that’s not been updated since the 1980s, so too would a business with a solid operating structure, updated technology systems and credible financials be more appealing to eager buyers.

In this highly competitive market, how are some middle market private equity buyers differentiating themselves with sellers?

Buyers are looking for the right price, the right terms, the right businesses for growth, the right people and the right fit for their portfolios. And for some private equity firms, particularly those in the middle market space, fit means focusing on a particular industry. More and more we’re seeing industry-specific private equity firms that have built a focus on one or two industries to really hone in on best practices related to that industry, industry contacts, operations and more. Having this deeper dive in a specific industry to invest in means buyers can leverage industry-centric knowledge to develop the businesses they acquire, thus differentiating themselves among the other more generalist buyer competition. In addition, being in the same industry as the seller, speaking the same language and knowing the industry nuances establishes goodwill and trust with the seller. You’re part of their community. You know them and you have a passion for their business. In these competitive times, that could be the X factor a middle market private equity needs to land the deal.

And once you’ve found that potentially right fit, buy-side due diligence can help reveal risks and opportunities so the private equity firm can make an informed decision about how and whether to proceed. Assessing earnings and cash flow quality, analyzing assets and liabilities, evaluating working capital, identifying internal control weaknesses, reviewing the purchase agreement and more are all key to assuring a solid transaction—especially during these competitive times.

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